Money-Market Strains Linger as Fed Prepares for Balance Sheet Shift

Tightness in U.S. money markets could extend through November as short-term funding costs remain elevated, prompting growing calls for the Federal Reserve to boost liquidity even before it halts its balance sheet runoff next month, according to Wall Street analysts.

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The final days of October capped a volatile stretch in funding markets, with the Secured Overnight Financing Rate (SOFR) a key benchmark reflecting borrowing costs backed by U.S. Treasuries spiking 18 basis points on Friday. It was the sharpest single-day increase outside of a Fed rate-hike cycle since the market turmoil of March 2020.

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Although SOFR eased on Monday as month-end pressures subsided, it continues to hover above critical Fed policy rates such as the federal funds rate. Other short-term borrowing benchmarks in the overnight repo market where financial institutions lend and borrow cash against high-quality collateral also remain elevated relative to the Fed’s target rates.

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“The Fed is running out of time, and it looks like they’re playing catch-up,” said Mark Cabana, head of U.S. interest rate strategy at Bank of America. “Pushing the QT end date to Dec. 1 was the only compromise they could make. But I think markets will soon force them to act.”

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Last week, the central bank announced plans to end the shrinking of its Treasury portfolio in December, wrapping up a three-year quantitative tightening (QT) campaign. The decision followed mounting signs of funding stress, as an influx of new government debt issuance since the summer has siphoned liquidity away from money markets at the same time the Fed continued to reduce its balance sheet.

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Bank of America had anticipated the Fed would conclude QT by late October and promptly resume modest asset purchases to expand reserves. The fact that no such move was made, Cabana said, shows diverging opinions within the central bank about how to manage liquidity going forward.

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Fed Chair Jerome Powell recently acknowledged that, “at a certain point,” the central bank would need to gradually rebuild reserves to match the growth of the banking system and the broader economy but he stopped short of providing a timeline. Some policymakers, such as Fed Vice Chair for Supervision Michelle Bowman, maintain that the Fed should strive for the smallest balance sheet feasible. A Fed spokesperson declined to comment on the internal debate.

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According to Bank of America strategists, the Fed has likely overdrained reserves reducing them to levels that, while still technically “ample,” are approaching the lower bound needed to prevent market distortions. As of the most recent data, bank reserves stood at $2.8 trillion, their lowest since September 2020.

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Dallas Fed President Lorie Logan, a former longtime New York Fed markets official, said Friday that the central bank might have to step in with asset purchases if repo rates remain elevated. She expressed disappointment that tri-party repo rates have exceeded the Fed’s interest on reserve balances (IORB) rate, emphasizing that money market rates should ideally trade near or slightly below that benchmark.

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By Friday, SOFR had surged 32 basis points above the IORB its widest gap since 2020 before easing to 4.13% on Monday. Still, that remains above both the IORB, now at 3.9%, and the effective federal funds rate, which the Fed recently lowered by a quarter point to a range of 3.75% to 4%.

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Similarly, the Tri-Party General Collateral Rate a key measure of overnight repo activity has been trading above 4%, exceeding the Fed’s administered rates since early October.

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Some strategists suggest the central bank may need to intervene temporarily to inject funds into the system during periods of heightened liquidity strain, such as Treasury settlement days or major payment dates.

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“We don’t rule out the possibility of temporary open market operations if funding pressures persist,” said John Velis, macro strategist at BNY. “If repo and SOFR rates keep grinding higher relative to the Fed’s own targets, the Fed might have no choice but to step in to calm things down.”

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In short, while the Fed’s plan to conclude quantitative tightening signals a gradual pivot toward easing liquidity pressures, market dynamics suggest it may need to act sooner than expected. Persistent stress in short-term funding markets could force the central bank’s hand testing its ability to maintain stability without undermining its broader monetary policy goals.

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